From the time markets open until trading closes, stock prices are in constant fluctuation.
Everything from a breakout news story to a shareholder meeting can impact a stock’s price. A lot of times, it has to do with supply and demand, such as we saw during the infamous GameStop surge, when a collective of small individual traders drove share prices up. While some lucky traders were able to sell the stock at its peak and profit, many traders hoping to make a quick buck instead lost money when the price eventually fell back down.
Nobody can predict every element that goes into stock price fluctuations, though many try. That’s what a hedge fund trader’s entire job is all about: trying to pool money together to maximize returns on investments, all while predicting — or influencing, some say — what the market does.
The everyday investor isn’t going to spend all day watching charts go up and down. That’s why we at NextAdvisor support a more passive investing approach and recommend that investors buy and hold index funds, including mutual funds and ETFs, which encapsulate broad compositions of securities stretching across industries and markets, rather than individual stocks.
One benefit of investing in index funds is that you can start building wealth even if you don’t have a lot of technical knowledge about the stock market. But for investors interested in adding individual stocks to their portfolio, it can be helpful to have a basic understanding of how to research stocks and monitor stock prices. That starts by paying attention to the news cycle, market conditions — and even your gut.
Here’s what you need to know.
What Factors Move Stock Prices?
Nearly any and all daily happenings can influence stock prices. The market, after all, is a reflection of how companies and industries are valued in our society. Being the fickle creatures that we are as human beings, our ideas of value change all the time.
Investing always carries some risk. That’s why it’s a good idea to spread out your investments among many different stocks.
Anything from a public relations crisis to breaking company news could impact a stock’s price. When investors, particularly at the hedge-fund level, sense cause for concern, we can watch that drama play out on the stock market. The same happens with factors like the Federal Reserve’s interest rate policies, geopolitical events like wars and boycotts, and even factors like innovation and technology, such as the hype we see around cryptocurrency right now.
“Many of these factors can be chalked up to ‘noise’ and increase daily price volatility,” says Jim Plumb, vice president and senior analyst at Illinois advisory firm, RMB Capital.
But one factor influences share prices more than any other: Profit.
“In the long run, stock prices converge toward the present value of future cash flows generated by the underlying business. Ultimately, these fundamental factors will have the greatest influence on stock prices,” says Plumb.
Ahead, we break down how the many factors work together to influence stock prices.
The two most fundamental factors boil down to profitability and the valuation ratio, says Juan Pablo Villamarin, CFA and senior investment analyst at Intercontinental Wealth Advisors.
“Profit is the ultimate result of many sub-factors — revenue potential, management competency (like governance, skills), and cost management,” Villamarin says. “Although slightly more abstract, the valuation ratio is the relationship between a certain financial metric (like earnings, revenue, cash flows) and the market value of the entity.”
The most famous metric is the price-to-earnings — or P/E — ratio. A P/E ratio is the ratio of a company’s share price to its earnings per share. Investors use these ratios to compare the performances of similar companies against one company’s records, both historical and projected earnings.
Technical factors are things that change the supply and demand of the stock that won’t fundamentally alter the prospects of generating cash, Plumb says.
“Take a stock split for example,” he says. “If company XYZ was trading at $100 per share with a total enterprise value of $100 million and offered a 2-1 stock split, the shares would now trade at $50 but the total enterprise value would not change since twice as many shares are now available,” he explains.
Even though it’s a stock split, Plumb says some investors are enticed by the lowered price, even though the business fundamentals didn’t change.
Technical factors can also include the time of day or specific days of the week a trade takes place compared to other days and times, says Villamarin. In addition, the price movement of one stock compared to the movement of another stock in the same industry or business sector can also influence the stock price.
“These technical factors may be important because they give insight into the supply and demand dynamics of the stock,” Villamarin says. “Some factors may reflect and predict the future demand for a stock,” he says.
Trends — both historically from the company and an industry as a whole — are considered technical factors.
If you’ve ever seen a company’s stock price go up or down following an earnings call, it’s because of the news.
“The trick is to decipher news that can have an impact on fundamental factors versus noise that can alter the short term supply and demand of a stock,” Plumb says. “News that changes the probability of a company’s ability to generate future cash flows can have a major impact on prices, especially if the impact is significantly different than current expectations.”
Quarterly earnings reports can cause the stock market to both dip and rise, although the effects aren’t always straightforward due to the myriad of factors involved in determining stock prices. In January 2021, for example, Apple shares fell in price despite the company reporting record quarterly profits.
Things happening in the world at large can also affect stock prices. Amid the COVID-19 pandemic, the stock market as a whole has taken a few major drops. The first was in March 2020 and the most recent was this summer as the Delta variant surged around the country, causing traders to worry about market recovery.
Market sentiment, or investor sentiment, is the investor outlook regarding a particular stock’s performance in the market. Sentiment drives demand, which also influences supply.
“It’s used to describe the expectations of the market regarding portions of metrics of the financial market,” Villamarin says. “Market sentiment matters profoundly because, at the end of the day, supply and demand forces are critical for the medium term movement of asset prices. Psychology is critical for market dynamics.”
There are several theories that try to explain how market sentiment can drive the supply and demand of stocks:
The Behavioral Financial Theory: This theory looks at psychological factors when analyzing financial markets. Some investors act on emotion and in some cases, overconfidence in a particular security or asset. These reactions can cause biased investing decisions, potentially hurting your investment.
The Animal Spirit Theory: This theory assumes that people act on instinct in situations of uncertainty, the same way animals are said to operate. In turn, actions — like making moves on the stock market — are also driven by instinct. When the market is good, investors will buy. When the market is bad, investors will sell. Even if the instinct isn’t necessarily right, it’s a driving force in decision-making.
“In periods of greed, market participants believe stock prices will continue to move higher and are willing to pay ever-increasing prices for stocks,” Plumb says. “Greed eventually turns to fear as investors begin to realize expectations have become too elevated and begin to sell stocks,” he adds.
Plumb says we can measure market sentiment using the CBOE Volatility Index (VIX), or the “fear index.” The higher the VIX goes, the higher the fear in traders. The lower the VIX, the lesser the fear. When the market is stressed, VIX goes up. The VIX averaged 15.4 in 2019 but reached an almost-record high of 82.69 at the beginning of the COVID-19 pandemic in March 2020, according to Reuters.
While using your instincts and intuition when investing, it’s easy to let your emotions get the best of you. Keep in mind that even with careful research, investing always carries some inherent risk. It’s a good idea to diversify your portfolio as much as possible, so that you’re spreading out your risk over multiple investments. An easy way to do this is by primarily investing in ETFs and index funds instead of individual stocks.
Index funds and ETFs are great ways to build wealth with relatively low maintenance and low barriers to entry. If you also want to invest in individual stocks, it’s always a good idea to do your research and become well-informed about a stock’s past and potential performance before buying anything.
Ultimately, though the stock market may have its ups and downs in the short term, investing is a great way to build wealth in the long term. Be sure that you’re investing smartly with a strategy that suits your financial goals, and keep your focus on your long-term goals (such as saving for retirement) to avoid making hasty decisions based on short-term panic or the fear of missing out.